Scott Sumner’s visit

It was great having him in residence for a few days and we discussed everything from Denmark to the financial crisis to the downturn of 1920-21 to the future of China.

I won't detail Scott's account of the crisis (see Scott here, or my pared down summary here), but in sum Scott believes that easier money at the critical turning point would have made a big difference. I have a few observations:

1. Scott's recommendation of higher price inflation, or higher nominal gdp growth, would have eased the crisis, in my very rough guesstimate by one-third and in absolute terms that is a lot. It's the best free lunch I've seen in years. Listen to Scott! Yet, in my view, easier money would not have eliminated most of the crisis, given the partial or total insolvency of many financial institutions, the negative AD shock from the collapse of the housing bubble, and the need to halt and reverse the ongoing accumulation of debt, among other factors. Scott disagrees.

2. Scott's account does not deny (but does not emphasize) that the initial downturn was accompanied by a fall in monetary velocity. This opens up room for real shocks, resource reallocations and recalculations, and animal spirits to be driving the broader story.

3. The relevant real shocks behind the downturn are plausibly: the decline of debt-financed consumption, mis-estimation of permissible leverage, the collapse of the real estate bubble, the revaluation of the risk premium, sectors hit by that revaluation, such as the non-profit sector suffering from tumbling equity prices, the required shrinkage of finance, sluggish behavior in the energy, health care, biotech, and educational sectors in terms of real productivity and job creation, and the collapse of non-Google advertising. I see the revaluation of the risk premium as the most important of those. And please note, when I refer to real shocks I don't mean technological forgetting or the Minnesota RBC theories.

4. Which empirical test would separate out the employment effects of the real shocks from the employment effects of the drop in nominal gdp? I observe that many of the ailing sectors have relatively flexible nominal wages (real estate agents and journalists are two such cases), which leads me to think the real shocks were more important. It would be good if we had a more formal test. If the nominal and real theories are observationally equivalent, my gut suggests that favors the real theories but I don't have a clear argument on that point.

5. I observe that the Eurozone (plus pegging Estonia) has a single monetary policy yet some fairly divergent outcomes. Estonian gdp has fallen off a cliff — about negative seventeen percent — while German gdp has fallen in the four to five percent range and now seems to have bottomed out. Note that Estonia probably has more flexible wages and prices than does Germany. Those facts also point to real shocks as being more important for the crisis, namely which economy was more bubbly in the first place and which required a greater revaluation of the risk premium. The ailing Spain is another example.

6. Many of the AD shocks in the crisis, such as resulted from the decline in housing wealth, come from shocks to real wealth or income, not shocks to nominal wealth or income.

7. Scott in his talk admitted and indeed emphasized that monetary and real shocks come bundled together. What methodological or empirical view would properly lead us to call one primary and the other secondary? Which came first? Which has a higher marginal product of destruction without the other? Which explains more pieces of data? Something else? I am inclined to call the real shocks primary and the secondary deflation…well…secondary. Scott portrays the deflation (he doesn't call it the "secondary deflation," as I do) as the primary problem.

Arnold Kling posts on these questions here and here. In Arnold's terminology I see the Fed as controlling nominal gdp but not always real gdp.

If you are looking to have in a visitor or a speaker, you cannot do better than to try Scott Sumner. Maybe someday Scott will tell you about his favorite movie director, or his views on India, either of which may count as his most absurd belief.

I am not sure how fast “real” shocks are supposed to propagate, but what about the emergence of China as the exporter to the world? Or the not unrelated rise in the cost of oil? These each have a whif of techno-shock in them.

In the UK, expectations of future inflation hit a high that autumn (from the NOP poll that the Bank of England does). Imported inflation was a big problem. They looked highly adaptive, rather than rational-expectation forward looking.

From the index-linked markets, we had expectations of future inflation at 3.6% in July 2008, so 1.6% outside the mandated level. Again, in the Scott Sumner world where the markets saw the deflation coming and were frantically signalling to the Bank to cut rates, this ought not to have happened. Once again, rather adaptive than rational (am I using these phrases right?)

I know we are a comparably more open economy than the US. But I cannot imagine a world in which SS’s prognosis would have been politically feasible, or worked even with the greatest hindsight.

Thanks Tyler, Just to be clear, I argued Lynch is the most talented living movie director, not my favorite. Wong Kar Wai is my favorite living director (despite My Blueberry Nights), and my favorite of all time is probably Hitchcock.

1. Your first point overlooks the fact that in a world of nominal debt and fragile banks a severe nominal shock causes a massive real shock in the financial system, just like what we saw in late 2008.

2. Although I generally don’t use the term “velocity,” my explanation implicitly assumes that a fall in velocity did “cause” the fall in NGDP, as the money supply didn’t fall. But of course more money could have offset this.

3. Except for the downturn in housing, most other factors you cited could be seen as either a symptom of falling NGDP, or as not significant enough to create a business cycle. The GDP slowdown between mid-2006 and mid-2008 was the sort of sluggishness you get from real shocks like the housing bubble bursting.

4. If the supply of labor is upward sloping (as in real estate) then a severe sectoral shock hitting real estate will cause unemployment even with wage flexibility. In all business cycle models where nominal shocks are important, there are uneven cyclical impacts to falling NGDP. And wage flexibility in severely impacted sectors can only moderate those sectoral impacts, not eliminate them.

5. In any large area, some regions will do better than others, even if a nominal shock is driving down GDP everywhere. In the US, the sub-prime crisis reduced real estate prices only in some regions. Then after August 2008 the fall in NGDP reduced real estate prices almost everywhere. You had both a real and a nominal shock.

6. This is important. Just as a loss of real wealth doesn’t cause families to decide it is the right time for a vacation, it doesn’t cause unemployment to rise. There is an Austrian story that resources had to move out of overbuilt sectors like housing. But that story only accounts frictional unemployment rising during 2006-08, not a massive rise in cyclical unemployment in 2008-09. It doesn’t explain why employment fell sharply in the industries people should have been moving into. Only falling NGDP and wage stickiness can explain that.

7. It is not a question of which came first, it is which of the two is controllable, and which can offset the other. Dispersed individuals can’t coordinate to achieve better animal spirits, but the Fed can offset a decline in animal spirits with more money.